Loading the player...

What is 'Uncovered Interest Rate Parity (UIP)'

Uncovered interest rate parity (UIP) is a proposition stating that the expected return on an uncovered, or unhedged, risk-free foreign currency investment should equal the return on a comparable domestic currency investment. When this relationship holds, the difference in interest rates between two countries will equal the relative change in currency foreign exchange rates over the same period. If the uncovered interest rate parity relationship does not hold, then there is an opportunity to make a risk-free profit using currency arbitrage or Forex arbitrage - Forex.

BREAKING DOWN 'Uncovered Interest Rate Parity (UIP)'

Uncovered interest rate parity (UIP) conditions consist of two return streams, one from the foreign money market interest rate on the investment and one from the change in the foreign currency spot rate. Said another way, uncovered interest rate parity assumes foreign exchange equilibrium, thus implying that the expected return of a domestic asset (i.e., a risk-free rate like a U.S. Treasury Bill or T-Bill) will equal the expected return of a foreign asset after adjusting for the change in foreign currency exchange spot rates.

There are two types of interest rate parity: covered interest rate parity and uncovered interest rate parity. When uncovered interest rate parity holds, there can be no excess return earned from simultaneously going long a higher-yielding currency investment and shorting a different lower-yielding currency investment or interest rate spread. Uncovered interest rate parity assumes that the country with the higher interest rate or risk-free money market yield will experience a depreciation in their domestic currency relative to the foreign currency.

Uncovered Interest Rate Parity Formula and Example

When UIP holds the following relationship exists:

%Change in Expected Future Spot Price S(f)/S(d) = i(f) - i(d)

This equation shows that the expected change in the future spot foreign exchange rate over the same investment period should be equal to the difference in interest rates.


S(d) = Domestic Country Expected Future Spot Price

S(f) = Foreign Country Expected Future Spot Price

i(f) = Risk-free Foreign Interest Rate

i(d) = Risk-free Domestic Interest Rate

The return on an uncovered foreign-currency risk-free investment is represented by the following equation:

(1 + i(f))(1 - %Change in Expected Future Spot Price S(f)/S(d) - 1

The Total Return is dependent on the future change in the expected future spot rate and can be approximated as:

i(f) ~= %Change in Expected Future Spot Price S(f)/S(d)

Empirically Analyzing Uncovered Interest Parity

There is only limited evidence to support UIP, but economists, academics and analysts still use it as theory and conceptual framework to represent rational expectation models. UIP requires the assumption that capital markets are efficient. Empirical evidence has shown that over the short- and medium-term time periods, the level of depreciation of the higher-yielding currency is less than the implications of uncovered interest rate parity. Many times, the higher-yielding currency has strengthened instead of weakened.

  1. Interest Rate Parity

    A theory in which the interest rate differential between two ...
  2. Parity Product

    A parity product is a brand of good that has enough similarities ...
  3. Law Of One Price

    The theory that the price of a given security, commodity or asset ...
  4. Covered Interest Arbitrage

    Covered interest arbitrage is a strategy where an investor uses ...
  5. Interest Rate Differential - IRD

    An interest rate differential measures the gap in interest rates ...
  6. Interest Rate

    Interest rate is the amount charged, expressed as a percentage ...
Related Articles
  1. Trading

    Using Interest Rate Parity to Trade Forex

    Learn the basics of forward exchange rates and hedging strategies to understand interest rate parity – fundamental knowledge for foreign-currency traders.
  2. Insights

    Purchasing Power Parity (PPP)

    Purchasing Power Parity (PPP) compares different countries' currencies through a market "basket of goods" approach. Two currencies are in PPP when a market basket of goods (taking into account ...
  3. Tech

    Parity Wallet Breach: $31 Million in Ethereum Stolen

    Parity Technologies advised users to move assets contained in the multi-sig wallet to a secure address.
  4. Trading

    An introduction to the international fisher effect

    The Fisher models have the ability to illustrate the expected relationship between interest rates, inflation and exchange rates.
  5. Trading

    Put-Call Parity and Arbitrage Opportunity

    These trades are profitable when the value of corresponding puts and calls diverge.
  6. Trading

    6 factors that influence exchange rates

    Here, you'll get in-depth look at out how a currency's relative value reflects a country's economic health and impacts your investment returns.
  7. Investing

    Solar Is Starting To Win The Price War

    For solar energy, the story has always been its price relative to fossil fuel prices. Grid parity with natural gas and coal is just around the corner.
  8. Trading

    How To Borrow For Free

    People will do anything to get a little extra money. If you need some cash, here are some ways you can borrow without much hassle.
  9. Retirement

    Things To Consider Before Retiring Abroad

    Before you retire to your dream destination, consider important factors such as banking, healthcare and purchasing power parity.
  1. How are NDFs (non-deliverable forwards) priced

    Understand more about non-deliverable forward contracts, or NDFs, and learn about the various factors that can have an effect ... Read Answer >>
  2. How do I convert a spot rate to a forward rate?

    The spot rate shows the cost of executing a financial transaction today, while the forward rate provides the cost of executing ... Read Answer >>
Hot Definitions
  1. Capital Asset Pricing Model - CAPM

    Capital Asset Pricing Model (CAPM) is a model that describes the relationship between risk and expected return and that is ...
  2. Return On Equity - ROE

    The profitability returned in direct relation to shareholders' investments is called the return on equity.
  3. Working Capital

    Working capital, also known as net working capital is a measure of a company's liquidity and operational efficiency.
  4. Bond

    A bond is a fixed income investment in which an investor loans money to an entity (corporate or governmental) that borrows ...
  5. Compound Annual Growth Rate - CAGR

    The Compound Annual Growth Rate (CAGR) is the mean annual growth rate of an investment over a specified period of time longer ...
  6. Net Present Value - NPV

    Net Present Value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows ...
Trading Center